Small business owners often find themselves in a situation where they have to evaluate a capital investment project and decide whether or not how to expand their company, purchase new equipment or move to a new location. Availability of internal funds and the ability to borrow money are often limited. So, making the decision on whether or not to move forward with a project or purchase is critical to the health of a business.
Let’s look at an example: Suppose an owner has an extremely popular restaurant and wants to take advantage of its esteemed reputation. Should the owner expand the existing facility or open a new location on the other side of town?
Expanding the existing restaurant will cost $75,000 and is expected to produce additional annual cash flow of $25,000. A new location will require an investment of $300,000. It is projected to have an annual cash flow of $75,000 after it is up and running for a few years.
Which of these projects should the owner choose?
Fortunately, several tools are available to evaluate a capital investment that will help small business owners determine the feasibility of each project:
- Payback method
- Net present value of cash flows
- Internal rate of return
Evaluate a Capital Investment with the Payback Method
The payback method is the simplest to use. It is the time needed for cash inflows to cover the initial cost of the investment. The formula is the initial investment divided by the annual cash flow.
Take the example of the choices facing the restaurant owner. The payback period for the expansion of the existing facility is three years ($75,000 divided by $25,000). Since the restaurant is already operating, the increase in cash flow will take place fairly quickly.
Alternatively, once there is a steady customer base, the payback period for opening a new location could be four years ($300,000 divided by $75,000). However, the cash flow for the early years after opening is uncertain, so the payback period may be longer.
The payback method has the following weaknesses:
- The payback method won’t include cash flows beyond the payback period.
- It does not consider the risk of receiving future cash flows.
- This method fails to take into account the time value of money.
Evaluate a Capital Investment with Net Present Value
Unlike the payback method, the net present value calculation considers the time value of money. It includes future cash flows after the payback period and for as long as the project generates cash.
NPV takes a stream of future cash flows and discounts them back to their present value at the current interest rate on loans or the rate of return required by an investor or owner.
The amount that the present value of cash inflows exceeds the present value of the initial investment is the project’s NPV. This makes it possible to compare projects to each other by determining which one has the highest NPV. This method has a bias toward larger projects. This is because larger projects can show higher a higher NPV than smaller projects which have fewer dollars invested.
You can adjust the discount rate used to calculate the NPV so that you can compensate for the risk level of future cash flows. In the restaurant example, the discount rate used to calculate the NPV for a new location will be higher because of the greater uncertainty of future cash flows. Cash flows from expansion of the existing facility is more certain.
Evaluate a Capital Investment with Internal Rate of Return
The internal rate of return for a project is the discount rate that makes the net present value of the investment equal to zero. You should consider accepting a project if its IRR exceeds your required hurdle rate. As the business owner, you determine your hurdle rate.
When using the IRR approach, you can compare projects with each other. Upon comparing, you should select the project with the higher IRR, assuming the IRR exceeds the required hurtle rate.
None of these methods will provide the ultimate answer by themselves. Each approach has its advantages and shortcomings. The payback method is simple to use but does not include cash flows beyond the payback period. The net present value calculations favor large projects over small ones. In addition, the internal rate of return gives multiple answers when cash flows are both positive and negative.
The most sensible approach is to use all three methods to get comparison figures for guidance and then apply experienced judgement and common sense.